 in this presentation we will discuss materiality determination or in other words how to determine materiality as we go through this note that we're still really in the planning of the audit stage and when we break out the audit we broke out the audit into stages worth thinking about support accounting instruction by clicking the link below giving you a free month membership to all of the content on our website broken out by category further broken out by course each course then organized in a logical reasonable fashion making it much more easy to find what you need than can be done on a youtube page we also include added resources such as excel practice problems pdf files and more like quick books backup files when applicable so once again click the link below for a free month membership to our website and all the content on it up this in the stages we had the client acceptance or continuance we had the preliminary engagement activities we got the planning of the audit then we consider an audit internal controls then we go through those audit business process and related accounts those substantive tests then we complete the audit and finally evaluate results and issue the audit report important to keep that in mind we're typically here we're focusing here mainly when we're thinking about the evaluation of materiality at the beginning of the audit so as we go through the audit we have an idea of what those materiality levels will be allowing us to better plan the audit and then execute that plan through the audit process so then first what is materiality once again this is going to be materiality as defined by the united states supreme court interpretation a fact is material if there is a substantial likelihood that the fact would have been viewed by a reasonable investor as having significantly altered the total mix of information made available so let's go through that a little bit again we're going to go through this again we got a fact is material if there is a substantial likelihood so again that word substantial likelihood it's going to be a key term because it adds some ambiguity what does that exactly mean we don't know exactly but we can get some kind of idea with that wording that the fact would have been viewed by a reasonable investor so similar to that term we always hear in the law reasonable person reasonable investor common sense type information it's kind of what we would think our mind goes towards with that but again some ambiguity in terms of what exactly materiality means in terms of a quant type quantifiable number as having significantly altered the total mix of information and I would interpret that to mean that this misstatement that we're looking at this misstatement that we're thinking about would tell us or have us alter the total mix in other words in our case usually the total financial statements or our opinion of those total financial statements due to the problem that is there typically a problem being an error or something that is omitted so how do we apply then materiality to an audit first of all we're going to determine the overall materiality and this is typically going to happen within the planning stage the overall type of materiality so we want to think about materiality as a whole as a total on the total financial statements then we're going to think about the determine the tolerable misstatement as we think about tolerable misstatement note what we're doing here we're saying this is the materiality level when we consider the materiality level we are thinking about then conversely that the level of misstatement then that would be tolerable we'll actually think about how much misstatement would be okay or under the threshold of a material misstatement which would not be okay so once we have the materiality level we could determine tolerable misstatements as we do so we're looking at the allocation of material materiality at individual account and class transaction level so now we're thinking about materiality not at the overall level not at the financial statements as a whole but at the individual accounts and the transaction levels that's going to give us a more defined kind of system that we can apply to actual audit processes because when we audit the financial statements we will be breaking that into the individual account and transaction level then we can evaluate the audit the auditing findings and that happens near the end of the audit process so we're going to say hey what's the overall maturity level materiality level then we're going to determine the tolerable misstatements and we're going to do that on the individual account type levels we're going to go through the audit then we're going to evaluate we're going to take this tolerable misstatement levels and take the results of our audit evaluate the audit findings that's going to happen towards the end of the audit where we're going to take what we found within the audit compared to what they determined overall materiality level is let's think about that in a bit more detail overall materiality determination quantitative benchmark used to establish overall materiality includes so this is the overall level this is what what happens at the beginning we're kind of thinking of the full financial statements as a whole so we need benchmarks to do this so when you're thinking about what would be a materiality level that we can think for the financial statements that as a whole we're thinking about those large benchmark numbers and you could just imagine well what how would I go about this how would I go about thinking about what's a material misstatement on the full financial statement level well the big numbers you'd be considering then is income before taxes so we might think about income before taxes or net income before taxes we might think about the total assets so when we're talking about tolerable misstatement or types of misstatement we're thinking about misstatements that might be material on the entire financial statement we might be using total assets then as some type of format to calculate what might be material and what might be not material notes receivable we might be using we might be using net assets or we might be using total equity and obviously total equity assets minus the liability giving the the total equity so these are the type of big type numbers that we would think of as we would be considering whether or not something would be material be a material misstatement or not now once we have the quantitative amounts that we're going to be used to determine the overall materiality they may be lowered by qualitative factors there might be qualitative factors in other words quantitative qualitative quantitative those do numerical factors the ones we really want because they're going to be a lot easier for us to work with numerical factors and qualitative factors that we can't put a number value to as easily but which we might take into consideration so the qualitative factors may include material misstatements in the prior year if there were material misstatements in the prior year that may affect our materiality our overall materiality determination in the current year high risk of fraud if there's a high risk of fraud for whatever reason possibly they're in a typical type of industry or something like that that has a high risk of fraud then that could affect our materiality threshold as well potential loan covenant violations so if there's any loan covenant violations that could be a problem small amounts that could cause the entity to forecasted revenues or earnings or affect the trend in earnings so anything that's good if there's a small amount that could be a higher risk and therefore materiality would be affected the entity is in a volatile business environment has complex operations or operates in a highly regulated industry these are also areas where once again we may say hey we're going to adjust the materiality level because of those risk factors tolerable misstatements so now we're moving to tolerable misstatement from overall materiality tolerable misstatement the amount of planning materiality allocated to an account or class of transactions so now we're talking about not the entity as a whole but we're talking about the account and class we're getting down to the more granular type level here combining tolerable misstatement is usually greater than planned material for the following reasons so at the end of the audit process we're going to look at the tolerable misstatement and we're going to think about the tolerable misstatements and compare them to the total misstatement for the total financial statements so in other words you might think that if we had the tolerable misstatements and we were to add up all the tolerable misstatements per account it should equal the total misstatement but that's not typically the case typically the tolerable misstatements as we allocate them to the accounts and classes if we were to add them all up would still be less than the total misstatement that we would be looking into for the full financial statement for the full audit for the following reasons. Not all accounts will be misstated by their full tolerable misstatement. So we're going to set a tolerable misstatement for each account and our hope of course is that as we audit these accounts that you know they're not going to be at the full tolerable misstatement and therefore when we add up the tolerable misstatement still be less than the overall misstatement for the full financial statements. The audits of individual accounts are conducted simultaneously. Materiality is often a small fraction of the account being audited and planning procedures will be enough to identify significant misstatements. So materiality is often a small fraction of the account and we're expecting that our planning procedures will be enough to identify the significant misstatements of course. When errors are found we usually have additional testing to that particular account which should reduce the amount as well. So typically at the end of the audit process when we think about adding up the tolerable misstatements they should be less than the overall materiality level. Misstatement and audit findings. As audit evidence is gathered the auditor aggregates misstatements from each account or class of transactions. So we're going to take these misstatements we're going to aggregate them together as we go through the process. So we're imagining in the timeline we had the overall misstatement or we had the materiality for the audit as a whole the financial statements as a whole then we thought about each individual account as we go through each individual account and thinking and comparing to the tolerable misstatement we will aggregate the misstatements from each account and class as we go through the auditing process. We're going to consider the effect of misstatements not adjusted in the prior year so we're going to look at the prior year look at the misstatements from the prior year we're going to compare the aggregate misstatement to the overall materiality then we're going to look at the aggregate meaning combining together all the misstatements comparing that to the overall materiality level we determined at the beginning of the process. If the aggregate misstatement is less than overall materiality the auditor can conclude that the financial statements are fairly presented. So then we're going to add up the misstatements and we're going to basically say is this less than the the the materiality level if it is then we can say that the financial statements are presented free of material material misstatement obviously including some component of audit risk and so that's going to be our process. So note again the goal here as we put this together is not to say we're going to eliminate all all risk all problems all errors are or problems whether it be due error or fraud our goal isn't to do that it's to set a reasonable level and then we're actually going to work of course that reasonable level into the audit process we're going to plan for what that level of materiality will be at the beginning we're going to then break that out by class and then we're going to add that up and check it out and compare it to what the overall level was at the end of the audit process.